Crossing Wall Street Review – June 16, 2017

The Federal Reserve Raises Interest Rates

On Wednesday afternoon, the Federal Reserve released its latest policy statement. The central bank said they raised their range for the Fed funds rate to between 1% and 1.25%. That’s an increase of 0.25%. This was the second rate hike this year, and the fourth of this cycle.

As I’ve said before, I think this move is a mistake, and I won’t belabor the arguments against the increase. It happened, and we have to move on. I’ll note that there was one dissenting voice, Neel Kashkari of the Minneapolis Fed, who agrees with me.

On Wednesday morning, just hours before the Fed’s statement, the government released the inflation report for May. The report again showed that there’s absolutely no threat of inflation on the horizon. If anything, the rate of inflation has fallen off sharply over the last three months. It’s hard to justify rate increases to fight off an inflation threat that doesn’t exist.

During May, the headline rate of inflation fell by 0.1%. Economists had been expecting no change. Some of that was due to falling prices for gasoline. That’s why we also want to look at the “core rate,” which excludes volatile food and energy prices. But the core rate for May only rose by 0.1%. There’s simply not much inflation out there.

You may recall that March was the weakest month for core inflation in over 30 years. As with all stats, we don’t want to be fooled by one-point trends. There are always outliers, so we want to see more evidence. Indeed, that evidence came in the last two months. Core inflation for April and May were the second- and third-weakest of the last three years, trailing only March. So it’s not only that inflation is low: it’s actually going lower.

More troubling is that we’ve seen a swift reaction in the bond market. On Tuesday, the yield on the 10-year Treasury dropped to 2.1%. That’s the lowest point all year. After the election last year, Treasury yields soared on economic optimism, but that’s largely faded in recent weeks. The spread between the two-year and ten-year Treasuries is now less than 80 basis points.

In the Fed’s policy, they acknowledge the recent weakness in the economy, but they seem to feel that it will soon pass. I hope they’re right, but I just don’t see the evidence just yet. In fact, this week’s retail-sales report was another dud. Economists had been expecting a gain of 0.1%. Instead, retail sales fell 0.3% in May. This was the biggest drop in 16 months.

But the Fed thinks they’ve only started raising rates. According to the latest Fed projections, they expect to raise rates one more time this year. After that, the outlook becomes a lot less clear (the blue dots get much more dispersed). The Fed sees three more hikes in 2018, and possibly three more in 2019. That means it’s possible that the 2/10 spread could be negative as early as next year. Still, I don’t want to be too alarmist. By the Fed’s own projections, they see real interest rates staying negative for another 18 months. My point is that we’re not in the danger zone just yet, but we can see it on the horizon.

The Fed also unveiled its plans for what they intend to do with their $4.2 trillion balance sheet, or as the Fed calls it, their “normalization plans.” The Fed said they plan to stop reinvesting the proceeds of their bonds in gradually increasing increments. It will be a long, long time before the balance sheet gets back to normal. But the key point is that the Fed intends to raise rates at the same time they address their balance sheet. That point wasn’t always so clear.

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